Psychology and Risk Management
• What to expect
• Risks
• Position sizing
• illusion of control
• Accepting critisism
• Paralyzed by fear
• Loss is a feedback, not a failure
• The flexible trader
• Focusing on the positive
• Short straddle
• The dynamics of greed
• The herd mentality
• Notes
2.1 – Acclimating to risk
A trader must also lose every rupee for every rupee they make in profits.
This leads us to the conclusion that there must be another group of traders that constantly lose money. What is Risk Management If one group of traders continuously makes money.
As opposed to the group of traders that consistently lose money, this group of traders making money is typically small.
Their approaches to money management and their perceptions of risk distinguish these two groups. According to Mark Douglas’ book, “The Disciplined Trader,” money management and strategy account for 80% of a trader’s performance.
Similarly, Risk assessment plays a big part in money management and related areas. So in this way, understanding risk and its many forms become vital at this stage. For this reason, let’s simplify risk to its most basic level in order to comprehend it better.
The likelihood of losing money is the typical layperson definition of risk in the context of the stock market. You run the risk of losing money when you trade in the markets, so be aware of this. For instance, whether you like it or not, when you purchase a company’s shares, you are taking a risk. Additionally, risk can be divided into two categories at a very high level: systemic risk and unsystematic risk.
Why do you stand to lose money, if you think about it? Or otherwise, what may cause the stock price to decline? There are a lot of reasons, as you can imagine, but here are a few:
- Declining business outlook
- decreasing profit margins
- management incompetence
- Margin reduction due to competition
Each of these has some level of risk. In fact, there may be a number of additional, related reasons, and the list is endless. You’ll notice that each of these hazards has one thing in common: they are all risks that are particular to the company.
The simple fact is that the events involving the corporation are solely to blame for the decline in stock price. The price decline is unaffected by any further outside causes. The decline in stock price at that time can only be attributed to internal or company-specific issues, which is a better way to phrase it. Unsystematic risk is the word used frequently to describe the danger of financial loss brought on by company-specific (or internal) factors.
You can diversify unsystematic risk by investing in a few different businesses rather than putting all of your money in one (preferably from different sectors). This is referred to as “diversification.” Investment diversification significantly lowers unsystematic risk.
Learning sharks start programme assures what you have been taught during the course goes into action.
Systemic risk is the riskthat all stocks on the markets face. Systemic risk is caused by common market factors including the macroeconomic environment, current politics, geographic stability, monetary system, etc. The following are a few key systemic issues that can cause stock prices to decline:
- decline in GDP
- increases in interest rates
- Inflation
- fiscal shortfall
- Geographical danger
Systemic risk, however, can be “hedged.” Hedging is a skill, a method one would do to eliminate systemic risk. Hedging might be compared to holding an umbrella on a gloomy day. You pull out your umbrella as soon as it starts to rain, covering your head right away.
Therefore, keep in mind that diversification and hedging are not the same thing when we discuss hedging.
Many market players mistake hedging for diversification. They are distinct from one another. Keep in mind that we diversify to reduce unsystemic risk. We utilise hedging to reduce systemic risk; nonetheless, it is important to note that no investment or trade in the market should ever be regarded as safe.
Expected Return (2.2)
Before, we return to the subject of risk, we’ll quickly discuss the idea of “Expected Return.” Everyone naturally wants to see a return on their investments. The expected return on investment is simple to understand; it is the return you would anticipate.
If you put money into Infosys with the expectation of getting a 20% return in a year, then 20% is all you can expect to get back.
Why is this significant, especially considering that it seems obvious? In finance, the concept of “anticipated return” is very important. This is the value we enter into a number of formulas, such as portfolio optimization or a straightforward assessment of the equity curve.
The expected return of a portfolio can be calculated with the following formula –
E(RP) = W1R1 + W2R2 + W3R3 + ———– + WnRn
Where,
E(RP) = Expected return of the portfolio
W = Weight of investment
R = Expected return of the individual asset
In the above example, the invested is Rs.25,000/- in each, hence the weight is 50% each. Expected return is 20% and 15% across both the investment. Hence –
E(RP) = 50% * 20% + 50% * 15%
= 10% + 7.5%
= 17.5%
Conclusion
- Lessons to be learned from this chapter
- You are exposed to both unsystemic and systemic risk when you purchase a stock.
- The risk that exists within the corporation is the unsystemic risk with respect to a stock.
- Unsystemic risk only affects the stock, not its competitors.
- Simple diversification can reduce unsystematic risk.
- The danger that permeates the system is called systemic risk.
- Systemic risk permeates all stock markets.
- To lessen systemic risk, one can use hedging.
- Since no hedge is perfect, there is always some risk involved with trading in the markets.
- The probabilistic anticipation of a return is known as the anticipated return.
- The anticipated return does not ensure that it will occur.
- The expected return for the portfolio can be estimated using the formula E(RP) = W1R1 + W2R2 + W3R3 + ———- + WnRn.
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